Balance Sheet Normalization Roadmaps

After expanding its balance sheet to $9 trillion during the pandemic, the Federal Reserve is working to shrink it back to a sustainable level. This process—balance sheet normalization—involves letting securities mature without reinvestment while monitoring for signs of reserve scarcity. The Fed aims to reach an "ample reserves" regime where the balance sheet is large enough to support monetary policy without creating excess liquidity or market distortions.

Normalization Goals: What the Fed Is Targeting

The Fed's objective is not to return to pre-2008 balance sheet levels. That era is over. Instead, the goal is reaching a balance sheet size consistent with "ample reserves"—enough reserves that the fed funds rate stays within the target range without requiring daily open market operations.

What "ample reserves" means:

• Banks hold enough reserves to meet payment needs and regulatory requirements
• The fed funds rate stays within the target range without Fed intervention
• Money market rates remain stable without unusual volatility
• The Fed can implement policy using administered rates (IORB, ON RRP) rather than daily fine-tuning

Estimated target levels:

The point is: The Fed is not targeting a specific number. It will shrink the balance sheet until it observes signs of reserve scarcity, then stop.

Runoff Caps: How the Shrinkage Works

The Fed uses monthly runoff caps to control the pace of balance sheet reduction. These caps set maximum amounts of securities that can roll off each month.

Current caps (as of late 2024):

• Treasury runoff cap: $25 billion per month (reduced from $60 billion in June 2024)
• MBS runoff cap: $35 billion per month
• Total maximum runoff: $60 billion per month

How caps work:

• When Treasuries mature, the Fed does not reinvest up to the cap amount
• If maturities exceed the cap, the Fed reinvests the excess into new Treasuries
• MBS prepayments (from refinancing and home sales) count toward MBS runoff
• If prepayments fall below the cap, actual runoff is smaller than the cap

Why the Fed slowed Treasury runoff: In June 2024, the Fed reduced Treasury runoff from $60 billion to $25 billion monthly. This slower pace allows more time to assess reserve conditions and reduces the risk of accidentally draining too many reserves.

Treasury vs. MBS Composition: Why It Matters

The Fed holds both Treasury securities and agency mortgage-backed securities, but it prefers to hold primarily Treasuries over time.

Why Treasuries are preferred:

• Treasuries are direct obligations of the U.S. government
• Treasury holdings minimize Fed influence on specific sectors
• MBS holdings affect housing markets and mortgage rates directly
• A Treasury-only portfolio is more neutral

The MBS challenge: MBS prepay when homeowners refinance or sell homes. In a high-rate environment, prepayments slow dramatically:

• At 3% mortgage rates: MBS prepay rapidly (homeowners refinance)
• At 7% mortgage rates: MBS prepay slowly (no refinancing incentive)

Current MBS runoff is running well below the $35 billion cap because few homeowners are refinancing out of their low-rate mortgages. The Fed may eventually sell MBS outright to reduce holdings faster, but has not announced such a program.

Current composition:

The durable lesson: The Fed wants a Treasury-heavy balance sheet but cannot easily reduce MBS holdings in a high-rate environment.

Timeline Expectations and Adjustment Triggers

Estimated timeline: At $60 billion monthly runoff, reducing the balance sheet from $7.0 trillion to $6.0 trillion would take approximately 16-18 months. However, actual runoff runs slower than caps due to MBS prepayment shortfalls.

Realistic estimate: Normalization may continue through 2025-2026 before the Fed reaches its target level.

What could accelerate normalization:

• Active MBS sales (not currently planned)
• Higher mortgage rates driving even slower MBS prepayments (counterintuitively this slows MBS runoff)
• Fed decision to increase Treasury runoff caps

What could slow or stop normalization:

• Signs of reserve scarcity (repo rate spikes, EFFR at top of range)
• Financial market stress
• Economic recession requiring policy easing
• Fed decision to restart QE

Adjustment triggers the Fed watches:

1. Reserve levels: If reserves approach $2.5 trillion, scarcity may emerge
2. Money market rates: EFFR persistently at top of target range signals tightness
3. Repo rate volatility: Spikes in overnight repo rates indicate funding stress
4. Discount window usage: Increased borrowing suggests bank liquidity pressure
5. Financial conditions: Broader tightening may prompt Fed to pause

What to Watch: Key Monitoring Indicators

Weekly data (H.4.1 release, Thursdays):

• Total securities held outright
• Treasury holdings (by maturity bucket)
• MBS holdings
• Reserve balances
• ON RRP usage

Daily data (NY Fed releases):

• Effective Federal Funds Rate
• SOFR (Secured Overnight Financing Rate)
• ON RRP take-up

Quarterly Fed communications:

• FOMC statement language on balance sheet
• Chair press conference comments
• Minutes discussion of runoff pace
• Vice Chair for Supervision statements on bank reserves

Holdings Breakdown Table

Current Fed balance sheet composition (approximate, December 2024):

Warning Signs of Reserve Scarcity

Monitor for these signals that the Fed may be approaching reserve scarcity:

Early warning:

• ON RRP usage falling below $100 billion
• EFFR consistently in top half of target range
• Repo rate volatility increasing around month-end
• Banks reporting tighter funding conditions

Moderate concern:

• EFFR at or above IORB
• Repo rates spiking above target range intermittently
• Fed conducting repo operations to add reserves
• Discount window borrowing increasing

Severe stress:

• EFFR persistently above target range
• Broad money market dysfunction
• Fed announcing emergency repo operations
• Fed pausing or ending QT

The test: Check the spread between EFFR and the bottom of the target range. If this spread narrows from the typical 8-12 bps to near zero, reserves are getting tight.

Checklist: Tracking Normalization Progress

Monthly assessment

• Review total balance sheet change vs. runoff caps
• Note actual Treasury vs. MBS runoff pace
• Calculate implied reserve balance trajectory
• Check Fed communications for any cap adjustments

Warning sign monitoring

• EFFR relative to target range (should be mid-to-lower)
• ON RRP usage trend (declining = tightening)
• Repo rate volatility (especially quarter-end)
• Reserve balance levels approaching $2.5-3.0 trillion

Fed communication tracking

• FOMC statement balance sheet language
• Press conference Q&A on runoff pace
• Minutes discussion of reserve conditions
• Fed speaker comments on normalization

Your Next Step

Download the Fed's H.4.1 release from the Federal Reserve website (published every Thursday). Create a simple spreadsheet tracking: (1) total securities held, (2) Treasury holdings, (3) MBS holdings, and (4) reserve balances. Update it weekly for one month. You will develop intuition for how fast the balance sheet is actually shrinking versus the announced caps—and whether reserve scarcity signals are emerging.

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